Recent COFC Decision Explores Intersection Between Limitation of Funds Clause and Indirect Costs

In late May, the Court of Federal Claims issued a decision in Reliability and Performance Technologies, LLC v. United States, No. 22-13, denying in part the government’s motion for summary judgment against a contractor’s claim for payment of indirect costs, including under the Allowable Cost and Payment clause. The government premised its motion on the contractor’s failure to provide notice under the Limitation of Funds clause. Upon reviewing Federal Circuit precedent, the court found that the nature of the particular contract — which the government repeatedly modified, both as to scope of work and funding ceiling — potentially excused the contractor’s noncompliance with the Limitation of Funds clause’s notice requirement. The decision also highlighted important pleading lessons for contractors. With this Advisory, we summarize the thorny interplay between Limitation of Funds and Costs clauses and a contractor’s entitlement to recover indirect costs, as well as our takeaways from the Reliability decision.

Background: Limitation of Funds and Costs Clauses

It is a common refrain that fixed-price contracts place the risk of overrun on the contractor and cost reimbursement contracts on the government. As to the latter, the Allowable Cost and Payment clause at FAR 52.216-7 generally provides the basis of a contractor’s entitlement to recover allowable direct and indirect costs. Potential government liability under cost reimbursement contracts is not unlimited, however. The Federal Acquisition Regulation (FAR) requires inclusion of one of two clauses in cost reimbursement contracts:

• FAR 52.232-20, Limitation of Cost (LoC), where a cost reimbursement contract is fully funded, which requires (in relevant part) that the contractor provide written notice to the contracting officer “whenever it has reason to believe that the costs it expects to incur … will exceed 75 percent of the estimated cost specified.”
• FAR 52.232-22, Limitation of Funds (LoF), where a cost reimbursement contract is incrementally funded, which requires (in relevant part) a similar notice when the contractor “has reason to believe that the costs it expects to incur … will exceed 75 percent of … the total amount so far allotted to the contract by the Government.”

See FAR 32.706-2 (requiring these clauses). Both clauses require that the contractor provide an estimated amount of costs or funds necessary to continue through the performance period. The premise of these clauses is the same: when the contractor has incurred costs approaching a certain threshold (of either the total contract amount or the total funded amount), the contractor must notify the government. If the government does not increase the cost or funding ceiling, then the contractor is not obligated to continue performance and conversely, cannot recover additional incurred costs above the ceiling.

The application of LoF and LoC clauses, while administratively burdensome, is relatively straightforward as to direct costs, but can present challenges when it comes to indirect costs, which are typically charged to the government through a provisional rate that can increase after the fact, if revised and when finalized. The Federal Circuit addressed this circumstance in Advanced Materials v. Perry, 108 F.3d 307 (Fed. Cir. 1997) — placing on the contractor the burden of recognizing when its incurred indirect costs are higher than any provisional rates it is charging under a contract. In that case, the circuit focused on whether the contractor had reason to believe that its incurred indirect costs would exceed its estimated costs (or, whether such increase was “reasonably foreseeable”), finding the contractor did have such a reason when it should have been tracking its indirect costs despite the limitations of its accounting system. The circuit summarized the test as follows: the contractor’s failure to provide a LoC notice should be excused when the contractor “through no fault or inadequacy on its own part, has no reason to believe, during performance that a cost overrun will occur” and the “sole ground” for the contracting officer’s refusal to fund an overrun is lack of notice. Absent these circumstances, the Advanced Materials decision confirmed that contractors are responsible for tracking incurred costs — both direct and indirect — in order to provide LoF and LoC notices, even if such estimates are necessarily non-final in nature.

Court of Federal Claims Decision in Reliability

In Reliability, the Court of Federal Claims considered a novel fact pattern involving the LoF clause and indirect costs. Reliability and Performance Technologies, LLC (Reliability) filed a three-count complaint against the Navy under the Contract Disputes Act, alleging breaches of contract (Counts II and III) and a breach of the implied duty of good faith and fair dealing (Count I) for the government’s failure to pay Reliability for its indirect costs on a cost reimbursement contract. The government filed a motion for summary judgment.

In its motion, the Navy argued that Reliability was not entitled to recover the indirect costs because it failed to provide the notice required by the LoF clause and separately, that Reliability released its right to recovery. The Navy also argued that the parties’ interactions do not support the implied duty breach alleged in Count I. The court granted the Navy’s motion for summary judgment as to Count I and denied it as to Counts II and III.

Overview of Contract

By way of background, the Navy awarded Reliability an incrementally funded Cost-Plus-Fixed-Fee (Term/Level of Effort) delivery order under an Indefinite Delivery, Indefinite Quantity contract to provide engineering and technical services. At the time of award, the Navy incrementally funded the delivery order in the amount of $201,353 and stated it would “allot additional amounts” through future modifications. The delivery order specified a total contract value of US$3,828,434.33. By the conclusion of the performance period, the Navy had increased the funding ceiling and contract value to US$25,493,486.51.

Relevantly, the contract incorporated the LoF clause at FAR 52.232-22 and the Allowable Cost and Payment clause at FAR 52.216-7, which as the court summarized, “requires the Government to pay the contractor for all allowable costs in accordance with FAR subpart 31.2 and the terms of the contract,” to include indirect costs, and also sets out the way in which the contractor shall bill for — and the government shall pay — indirect costs, until final indirect rates are established.

Reliability’s Claim

The claim involved US$1,094,060.62 in unreimbursed indirect costs that Reliability incurred from FY2012-FY2015, which exceeded the interim amounts Reliability charged the Navy during performance. The contracting officer denied the claim, citing Reliability’s failure to provide notice under the LoF clause. The Navy did not contend — in either the contracting officer’s final decision or subsequent litigation — that the indirect costs were otherwise unallowable. Reliability then filed its complaint with the Court of Federal Claims, appealing the decision.

Limitation of Funds Clause Is Not an Absolute Bar

With its motion for summary judgment, the Navy first argued that the LoF clause “excused” the government “from any obligation it had to timely negotiate and pay Reliability for its indirect costs in accordance with the Allowable Cost and Payment clause.” The court disagreed.

The court distinguished the Federal Circuit’s decision in Advanced Materials, which barred a contractor’s recovery of indirect costs due to its failure to comply with the LoC clause, by explaining that the contract in Advanced Materials was for “specified work” and that a contractor exceeding its own cost estimate for that work was a “classic ‘overrun.’” By contrast, the delivery order at issue was “for unidentified ‘emergent work’” that the Navy “elected to expand” in “scope … when it desired” — in the form of 67 modifications, “nearly all of which either increased the incremental funds allotted to the contract or the overall contract value.” Unlike Advanced Materials, where the circuit found the contractor’s failure to provide prospective cost estimates was detrimental “because the contractor had all relevant information and control over the cost and schedule of completing the specified work since the contract specified all of the work that needed to be done upfront,” here the government was the party that held the information regarding what future work would be required.

The court also found, in viewing the evidence most favorable to the contractor, that it was possible that the Navy “failed to comply with the Allowable Cost and Payment clause by: (1) not promptly negotiating final indirect rates and (2) by not adjusting the billing rates sufficiently to avoid the variance between the incurred costs and the final indirect rates resulting in a substantial underpayment to Reliability.”

Regarding the first alleged breach of contract, the court noted that, while Reliability timely submitted indirect cost proposals, the government did not issue final indirect rates for over six years. The government alleged that any delay was “attributable to failures in Reliability’s cost accounting system,” citing a Defense Contract Audit Agency (DCAA) finding that Reliability’s accounting books and records for FY2012 and FY2013 were inadequate. However, the court determined that “the adequacy of Reliability’s audit [sic] system is factually disputable” (especially given contrary DCAA statements on the issue over time) and that “a factfinder could reasonably conclude that the Government … did not have a valid basis to delay its negotiation of the final indirect rates.” Regarding the second alleged breach, the court explained that “the Allowable Cost and Payment clause required the Government to pay Reliability for its indirect costs at billing rates established by the Contracting Officer in a way that aligns as closely as possible to the final indirect rates.” As the Navy never disputed the allowability of the US$1,094,060.62 variance between the indirect rates at which Reliability billed the government and its final indirect rates, a factfinder could reasonably conclude that the government violated its obligation under the Allowable Cost and Payment clause to pay Reliability for its indirect costs at rates that are not a “substantial … underpayment” of the “anticipated final rates.”

Reliability May Demonstrate It Did Not Release Claims

After denying the government’s motion for summary judgment on the LoF issue, the court also declined to find that Reliability had released its right to recovery. The Navy argued that the agreement by which Reliability and the government established final indirect rates for FY2012-FY2013 released all future claims related to Reliability’s indirect costs for those years. For this, the government cited the following language from the agreement:

• “In all other respects, [Reliability] releases the Government from any and all further liability or claims described in [Reliability’s preceding request for equitable adjustment for indirect costs from FY2012-FY2013.]”
• “Along with each final voucher, [Reliability] will provide to the [Contracting Officer], any applicable release of claims that will be expressly subject to and conditioned upon payment by the United States Government of said invoice or voucher[.]”

The court found Reliability’s assertion regarding the first bullet — that “this language is only a release of a portion of the claims described in the letter” — to be “plausible,” reasoning that the entire “purpose of the agreement was to establish final indirect rates. Why would the parties execute an agreement containing a provision that essentially waived enforcement of the entire agreement?” The court also noted that the government’s interpretation voided the text in the second bullet, which contemplates future releases. The court could not reconcile the government’s interpretation, concluding that “the problem with the Government’s interpretation is that it does not adequately explain how the release relates to the very agreement in which it is contained.” Thus, the court determined that it “cannot conclude as a matter of law that the FY2012 and FY2013 indirect rate agreements operate as a release” and denied the Navy’s motion on this basis as well.

Navy Did Not Breach the Implied Duty of Good Faith and Fair Dealing

The court concluded its decision by granting the government’s motion for summary judgment as to Reliability’s claim that the Navy breached the implied duty of good faith and fair dealing. To plead this count, Reliability first alleged that the government failed to conduct audits in violation of the contract. The court concluded that these allegations were “legally indistinguishable” from Reliability’s breach of contract claims and thus “there is no need to consider them again as a separate cause of action.” The court was also unconvinced by Reliability’s argument that it detrimentally relied on contracting officer guidance to submit its indirect cost proposal after the performance period, holding that Reliability’s exchange with the government was “no more than the contracting officers communicating how the process generally unfolds,” and was not a “direction” to act by the contracting officer.

Prior Court of Federal Claims Decisions

The Reliability decision is only the Court of Federal Claims’ latest foray into how the LoF and LoC clauses can impact recovery of indirect costs, as well as the “reasonably foreseeable” standard the Federal Circuit enunciated in Advanced Materials for when a contractor is or is not excused from complying with the applicable notice requirement. An overview of those decisions sheds light on the circumstances in which contractors encounter challenges complying with the notice requirement, and how the court has applied (and in some instances, evolved) the standard set out by the circuit when assessing whether the contractor’s noncompliance precludes recovery. To summarize:

• In Johnson Controls World Servs., Inc. v. United States, 48 Fed. Cl. 479 (2001), the court excused a contractor’s failure to provide notice under the LoC clause because the contractor was “not in a position to reasonably foresee” that indirect costs related to its insurance premiums “would increase so dramatically.” Describing the purpose of the LoC clause as “protecting the Government and the contractor from unfunded overruns” (emphasis added), the court concluded that the LoC clause did not preclude the contractor’s recovery where “the cost overruns are attributable to escalation in the values of workers’ compensation and liability claims and that [the contractor] was unable to avoid the costs of a claim once it had been made,” and where “these escalations occurred after the termination of the contract, so that [the contractor] was unable to cease work.” Notably, in reaching this decision, the court set out a legal standard that seemingly expands the Advanced Materials standard into a five-prong test for when a contractor’s noncompliance with the applicable notice requirement does not bar recovery.¹
• In International Science and Technology Institute, Inc. v. United States, 53 Fed. Cl. 798 (2002), the court cited the Johnson Controls standard and concluded that the contractor “should have known that it would have incurred cost overruns in indirect expenses at the time it incurred expenses, such as long-term leases and salaries” and that, unlike in Johnson Controls, the contractor “could have notified the contracting officer of the cost overruns at a sufficiently early time when at least some of these expenses could have been avoided.” Thus, the contractor was not excused from failing to comply with the LoF clause.
• By contrast, while also citing the Johnson Controls standard, the court in Viacom, Inc. v. United States, 70 Fed. Cl. 649, 657-58 (2006), concluded that costs related to a segment closure were not reasonably foreseeable and were not avoidable by the contractor during performance, thereby excusing the contractor’s failure to provide notice under the LoF and LoC clauses.
• Most recently, in InterImage, Inc. v. United States, 146 Fed. Cl. 615 (2020), when faced with a contractor’s claim for cost overruns, the government invoked the LoF and LoC clauses to argue that the contractor “had a duty (1) to maintain its accounting system to ensure timely knowledge of cost overruns before the costs are incurred and (2) to evaluate properly the financial data that the accounting system generates” (citations omitted). The contractor responded that when finalizing its indirect rates, the government “used a different base for calculating the final indirect rates than InterImage had used to calculate its provisional rates, and that the attributable cost difference was unknowable” (italics omitted). The government contested the use of different bases as a factual matter, but when confronted with this dispute over a material fact, the court denied summary judgment.²

Takeaways From the Reliability Decision

Taken together with Federal Circuit precedent and the preceding Court of Federal Claims decisions, the Reliability decision lays the groundwork for another potential basis for a contractor to recover indirect costs that a contractor failed to account for in its required notice under the LoF or LoC clause — namely, where a contract is not for specified work, but rather, for services where the government is in sole control of the scope of work and thus, the costs or funds required to perform.

The court in Reliability placed emphasis on which party was in possession or control of the relevant information: the contractor, as the entity incurring the costs, versus the government, as the entity responsible for paying the costs under a cost reimbursement contract. Ordinarily, and as was the case in Advanced Materials, the LoF or LoC clause protects the government from incurring liability without adequate notice, while excusing the contractor from such notice where the contractor also lacks the relevant knowledge — or, as the clauses put it, “reason to believe” that it will exceed the relevant threshold.

Given the nature of the delivery order at issue in Reliability, the court was not convinced that the contractor was in possession of the information pertinent to whether it would exceed the funding threshold. By its very nature, the delivery order afforded the Navy latitude to increase the funding ceiling as it increased the scope of work. The Navy took advantage of this latitude by issuing “sixty-seven modifications, nearly all of which either increased the incremental funds allotted to the contract or the overall contract value,” which experienced “an approximately 550% increase” over contract performance. A future merits decision in Reliability may reveal the contours of this potential exception to the LoF and LoC notice requirement, which could have broad application in the most complex government contract awards with constantly shifting scopes of work and funding ceilings.

The Reliability decision also provides two insights on pleading. First, while contractor complaints often plead a breach of the implied duty of good faith and fair dealing count (sometimes in the alternative), the court may be more inclined to grant summary judgment for the government on an implied duty breach where the focus of that count is the same as a standalone count for breach of contract. This includes overlapping allegations as well as damages, which the court in Reliability specifically called out — noting that “the damages Reliability seeks for this allegation are for the exact same thing, indirect costs, and the exact same amount.”

Second, where the government points to a contractor’s failure to provide notice under a LoF or LoC clause as its reason for not paying indirect costs, the contractor may be well-served by pleading that the government’s failure to make payment constitutes a breach of the Allowable Cost and Payment clause of the contract. This is particularly true where the government has not otherwise disputed the allowability of the indirect costs at issue. In Reliability, the court concluded that the government’s alleged failures to comply with the Allowable Cost and Payment clause were “valid bases for breach of contract” and that such alleged breaches distinguished the case from Advanced Materials. And significantly, because “a factfinder could reasonably conclude the Government failed to comply with the Allowable Cost and Payment clause,” the government was not entitled to summary judgment on Reliability’s breach of contract claims.

© Arnold & Porter Kaye Scholer LLP 2024 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.